Sunday, June 28, 2009

Wealth effect and the savings patterns

Over two decades of unprecedented increases in asset (homes, bonds and equities) values, with their resultant "wealth effect" (use the assets like ATMs to draw down cash), coupled with historically low interest rates and a booming economy, had driven Americans to spend as though there were no tomorrow. Now, battered by a collapsing housing market, asset values that have plummetted to their depths (wiping out household net worth at an alarming rate), and an economy in deep recession, Americans appear to have dusted up their piggy banks and resumed the long forgotten habit of saving for the rainy day.

Comparing patterns in household savings as a share of disposable incomes in US, UK, Canada and Germany, and finding similarities in the same, Rebecca Wilder feels that "wealth effect", more than "de-leveraging" (propensity to reduce debt burdens), may be the dominant determinant of savings patterns. First, though, Canadian and German households did not experience the bubble in debt accumulation as did the US and UK households, saving rates are rising across the board.

Second, as a comparison of the ratio of net-worth (nominal wealth) to disposable income in the US and Canada shows, the wealth effect (reflected in the much steeper declines in the ratio as the asset values boomed) is much more pronounced in the US. Despite this, the savings rate have been climbing in both countries.

Both these trends taken together lends credence to the view that wealth effect is the more important determinant of household savings and the effect of high debt burdens may be more marginal than conventional wisdom would have it. By implication, as Wilder writes, this view also means that "the second the labor market starts to improve, and credit standards loosen up further, US households (may) start spending again. All that is needed is a little income growth to generate some consumption growth alongside constant debt payments."